Mired in its weakest recovery since the end of the Second World War, paralysed by joblessness and political gridlock, and eyeing a fifth year of trillion-dollar deficits and Fed stimulus, America is not a happy camping ground.

Yet among the small club of major Western economies that called the shots in global finance until about 10 years ago, America still stands out as a virtual tower of strength.

But that’s still not saying much. The US government only just scrambled off the fiscal cliff but more bitter budget battles are looming as politicians squabble about how to repair the country’s finances in the long term.

Investors are battling to make sense of the times. They cheered the fiscal cliff deal when markets reopened on Wednesday with their best opening day surge – 2.35 per cent – since 2009. But they soon thought better off it after Moody’s Investor Services warned the agreement might not be enough to maintain the government’s triple-A credit rating.

However, if America scrapes past the debt ceiling and other fiscal deadlines due in March, it can at least expect growth this year of between 1.5 per cent and 2 per cent and a – painfully slow – reduction in its 7.7 per cent unemployment rate.

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Which is a lot more than the Europeans, the Japanese and the British can look forward to.

The euro zone, Japan and the UK have slipped into another recession, or are about to, and are desperate to find a way to fire their creaking, overburdened engines of growth. America is doing better comparatively but not nearly well enough for its politicians, voters or businesses.

Friction and suspicion

The struggles of Western economies are causing friction and suspicion. The Europeans tried austerity but as their problems deepened, the European Central Bank relented and agreed to buy their sovereign bonds.

There is no template and no precedent for these huge monetary efforts. Central banks are embarking on a journey with no road map and only a vague exit strategy. Critics argue they are just “monetising debt" and aggravating “currency wars"; that is, competitive devaluations aimed at boosting exports at the expense of other nations.

The Reserve Bank of Australia quietly joined this critical chorus in recent weeks.

Critics say quantitative easing is sowing the seeds of the next financial crisis as excess liquidity and low interest rates force investors to chase yield and drive up the prices of bonds and riskier assets.

Trade barriers and retaliation against so-called unfair exports are increasing; the US and Europe have attacked China’s automobile parts exports.

A coalition of pressures, from weak demand and a revival of protectionism to bank lending limits and stiffer financial regulations, is driving globalisation into retreat for the first time in a generation.

Japan is the latest to succumb to the temptation to expand deficit spending and force its central bank to permit unlimited monetary easing in an effort to boost inflation and growth.

Yet it has been down this path before. Two decades of stagnation have left a ruinous government debt and many fear Japan is the model that proves what can happen when a nation resorts to unlimited stimulus.

The question is whether Europe and the US will suffer the same consequences. At least one expert considers it is possible.

“I think there’s a very good chance of comparable – hopefully not as long-lasting – shortfalls in economic growth in the US and Europe," Stephen Roach, senior fellow at Yale University and former chairman of Morgan Stanley Asia, told the Weekend Financial Review.

Despite Japan’s record, newly elected Prime Minister
Shinzo Abe
and his Finance Minister
Taro Aso
last week blamed the US and Europe for exacerbating global woes. In particular, Abe complained both were allowing their currencies to slide against the yen.

This week, Taro Aso reminded the media of an agreement made among G20 nations nearly four years ago not to resort to competitive devaluations.“Tell me how many countries in the G20 have stuck to that promise?" he asked.

“We’re the only ones doing things properly. Foreign countries are in no position to lecture us."

What is clear amid the murk is that powerful countries or trading blocs from the US to Europe and Japan have embarked on the sort of monetary easing that risks intensifying the currency war.

Meanwhile, Japan and its debts threaten to displace Europe as the main problem in the global economy this year.

A budget deficit of 9 per cent to 10 per cent will drive Japanese public debt to a vertigo-inducing 245 per cent of the country’s gross domestic product. The economy will barely grow this year without the extra stimulus promised by Abe and Aso; even then, it may not.

Also, Japan’s workforce is shrinking. The retirement of baby boomers could force the government to rely on foreign rather than domestic savings, increasing the cost of its debt to international yields.

A small increase in interest rates would wreak havoc with Japan’s finances, triggering unprecedented problems for the newly elected government, says Carl Weinberg, chief economist at High Frequency Economics. “Japan’s economy is our principal ‘worry spot’ for 2013," he says in a note.

Risk of contagion

So with Japan, Europe and the US struggling, the problem can be expected to spread. There is a risk of contagion given these are the dominant global economies. Countries from China and Brazil to others in East Asia and South America that depend on exports will be affected.

That means Australia has a greater stake in the fortunes of the major Western economies than their share of our exports might suggest.

“Australia cannot remain an oasis of prosperity in an otherwise struggling world," says Stephen Roach. “For China, it just underscores the fact that all this talk about rebalancing over the last five years has now got to be followed by implementation and execution of a pro-consumption growth strategy. And if that does not occur, then China will also suffer it’s own version of the Japan disease."

Whether the major Western economies are the authors of their predicaments or victims of clever currency manipulation by China and other emerging economies, or a combination of both, depends on your point of view. In any case, they are not in control of their destinies to nearly the same extent as in the 1980s and ‘90s.

The harshest view says rich nations are in denial; that as baby boomers swell the ranks of retirees, rich nations are unable to accept that they can’t count on past growth rates to generate the revenue to pay for their welfare states.

“The big mistake was made probably beginning in the case of Japan in the late ‘80s and in the rest of the developed world beginning in the late ‘90s when slow growth was just not politically acceptable to elected officials," says Roach.

“They started to experiment with extracting more growth from their economies by very dangerous financial engineering, in particular extracting unsustainable growth in purchasing power from asset bubbles and credit markets.

“And that got them into serious difficulty which led to bubbles and their aftermath and it’s pretty hard to stuff that genie back into the bottle."

A kinder view says rich nations are simply responding the only way they can to the aggressively mercantilist trade policies of economies such as China, Hong Kong, Singapore, Korea and Taiwan, says Joseph Gagnon, senior fellow at the Peterson Institute for International Economics.

Even though it is now complaining it is a victim, Japan is also in this group.

So are Switzerland and several oil-exporting countries.

Floods of capital from these countries, estimated in a recent Peterson Institute paper to be one trillion dollars a year, have enabled the US, Europe and Japan to use quantitative easing and fiscal policy to boost growth, Gagnon says.

But the limits on QE – with interest rates in the US as low as they can go – and fiscal stimulus in already deeply indebted economies, have been reached.

“They are being pushed to the wall by those capital flows and they’re unable to respond to get growth," he says.

“They wouldn’t have such big deficits if they weren’t being pushed into such deep recessions."

The idea of the US, Europe and Japan as victims may be hard to square with their financial history but it reflects their diminished power, Gagnon says.

“They don’t dominate the world economy. They can’t afford to ignore what the rest of the world does any more and the rest of the world can’t afford to pretend that it doesn’t matter any more.

“China has to understand that what it does matters, for the first time in history, and the US has to understand that it’s not all powerful."

The flow of capital from emerging economies is letting the US and Japan off the hook on fiscal reform (Europe is already labouring under austerity).

What is the solution?

Given these huge trade imbalances – endless capital from the east to permit spending in the indebted West – what is the solution?

Treasurer
Wayne Swan
has argued at the G20, which Australia hosts next year, that developing countries need to shift their emphasis from exports to domestic consumption to help right the balance.

With this in mind, Swan wants to encourage developing giants like China, India and Brazil to invest much more in their patchy infrastructure.

The idea is that there would be a trade-off: it would force China and other emerging economies to take more responsibility for their role in global imbalances in exchange for obtaining more power in global governance.

Gagnon says: “If these countries would grow more domestically, then the urgency of US fiscal reform would be greater because our interest rates would start to go up and the inflation rate might start to rise again, and then we would have to cut our budget deficit."

He is sanguine about the potential consequences of quantitative easing and doesn’t see a catastrophe in Japan or Japan-style stagnation in the US and the euro zone, saying central banks are just doing what they have to do.

Some economists think the US – if policymakers can agree on a decent budget reform package – will see a wave of investment and shale energy-fuelled demand that could drive growth towards 3 per cent as early as this year.

That might prompt the US Federal Reserve to raise rates from near zero and perhaps start to unwind its $US3 trillion QE balance sheet earlier than 2015.

But the fact remains that the US is struggling to reach escape velocity, even though the Fed and other central banks have stretched their balance sheets to the limit with bond purchases.

Central banks – or the governments to which they are answerable one way or another – have brought themselves to a historic “reverse-Volcker moment" by prioritising jobs over inflation, says Mohamed El-Erian, chief executive of the world’s largest private bond fund, Pimco.

Former Fed chairman Paul Volcker’s victory over inflation was hard won, with pain via 22 per cent interest rates traded for future gain. Yet last month, Fed chairman
Ben Bernanke
said the Fed would aim for a 6.5 per cent unemployment rate as long as its inflation projection remained within 2.5 per cent – that is, above the target of 2 per cent.

The UK government said it would consider a similar change and recently appointed Canadian central banker Mark Carney the governor of the Bank of England. And Japan’s Shinzo Abe has made no secret of his desire to appoint a more pliable governor to the Bank of Japan.

In an article published by Project Syndicate last week, El-Erian says central banks’ concern about entrenched joblessness is understandable while “bickering politicians" squib fiscal and structural reforms but central banks lack the tools to solve the problem.

“The best that central banks can do is to buy time, albeit at an increasing cost, for other policymaking entities to get their act together," El-Erian says.

“If this window closes, the monetary policy paradigm shift now visible in the US, Britain, and Japan would risk a damaging loss of credibility and political independence for institutions that are critical to well-managed economies."

Sensitive to criticism that the Fed is monetising debt, Bernanke said last month that such a scenario would only be a danger if the Fed intended to hold its $US1.6 trillion of Treasury securities in the long term. But that sounded a bit strained.

“We’ve been waiting for the exit strategy for over four years and it looks like we have several years to go," says Stephen Roach.

To Roach, the danger of quantitative easing is that it is “blurring the distinction between monetary and fiscal policy and avoiding the discipline of higher borrowing costs that might otherwise create a more meaningful and lasting fiscal restraint in the United States".